Nick Rowe has a post up from a week ago on macroeconomic policy. He points out that as long as we have a central bank, that central bank will be affecting the macroeconomy, so it doesn’t really matter whether we need a central bank to stabilize the economy. The only relevant question is what the central bank should do. In Nick’s view the old question was whether the central bank should follow rules or act on a discretionary basis, but now there’s a fairly strong consensus in favor of rules and the debate centers on whether central bank monetary policy can be effective in contemporary circumstances (i.e. at the zero lower bound).
Nick argues that monetary policy can be effective — the central bank just needs to keep buying something in order to put more money into circulation. He rejects the view buying private sector assets ends up being fiscal policy and argues that it can be kept neutral (as opposed to the picking of winners and losers that characterizes fiscal policy) by, for example, having the central bank buy the index of all marketable securities.
My model of a central bank is based on the role of the Bank of England in the early 20th century and thus it is very different from Nick’s (and from that of most macroeconomists). I don’t understand how it could ever be possible for monetary policy — or for a one-dimensional policy tool that adjusts either “M” or “i” — to stabilize the economy. To stabilize the economy the central bank needs to monitor and discipline the flow of credit through the banking system. It needs a window on how credit is flowing to the different sectors of the economy. And when the banks are allowing so much credit to flow to a certain sector that prices are becoming (or are likely to become) misaligned in that sector, the central bank needs to force the banks to restrict the flow to that sector.
In short, I think the focus on one-dimensional monetary policy is the reason we had the mother of all financial crises — and let’s be clear, from the British perspective this crisis was indisputably worse than any crisis experienced over the past two centuries with the possible exception of the outbreak of World War I.
Macroeconomists need to start thinking outside their general equilibrium models where there are no relative price distortions, and understand that the banking system has the capacity not just to inflate prices, but also to distort prices. And that when these prices get so out of line that readjustment is forced, the result is often disruptive. Thus, the important tasks of the central bank include keeping an eye on the flow of bank credit and taking quick action when this flow is clearly out of kilter.
Let me give a specific example. From mid-2004 to mid-2006 the Federal Reserve was raising interest rates. At the same time the origination of adjustable rate mortgages which have interest rates that are very sensitive to the short-term rate did not fall, but actually rose and remained elevated throughout the period of rising rates. (Compare Figure 14 with Figure 17 here.) When significant increases in interest rates have no effect on the quantity of credit, alarm bells need to start going off at the Fed. This is a clear indicator of Ponzi finance.
And we all know what was happening to housing prices as the same time that mortgage credit markets were clearly out of whack. The Federal Reserve should have observed the clear indicators of dysfunction in mortgage markets, and it should have taken action to adjust the flow of credit. If the Fed recognized this duty, the housing bubble would have been much less severe.
Unfortunately the Fed was very much focused on one-dimensional policy. If the Fed wants to stabilize the economy, it will have monitor the flow of credit through the economy and be ready to take action to address any markets where the data makes it clear that something is going very wrong.